QE3 and the FED: State-contingency and commitment emphasized

Today the Board of Governors of the Federal Reserve System published its decision to start a new round of quantitative easing and a revised announcement concerning the Federal Funds rate. Both legs of this decision have some interesting new aspects that show a central bank continually trying to expand the toolbox of monetary policy, and to be honest about its limitations when acting in an uncertain world. More specifically, the Fed re-introduces purchases of mortgage-backed securities (MBS) at a rate of $40 billion per month. No end date for the purchases is specified—at the contrary, it is emphasized that it will be extended if the economy does not pick up. Moreover, the 0–0.25% level for the Federal Funds rate is kept at least until mid 2015, but with the new qualifier that it will not be lowered, even when the economy picks up.

At the press-conference with Chairman Ben Bernanke, he elaborated on these aspects (aided by quite insightful questions from the press). Bernanke made it clear that at the lower bound, the Fed’s policy instruments are essentially balance sheet manipulation and communication.

Indeed, the quantitative easing of MBS belongs to the first category. Of course, at the press conference, Bernanke was asked whether this “QE3” will be effective at all. Many seem to acknowledge the effects on interest rates and asset prices, but many doubts that the effects go further. So, as one reported formulated it, will this policy actually go from Wall Street to Main Street? Bernanke emphasized that the role of monetary policy is to affect financial prices and that the Fed was convinced that there would be an effect on the real economy. However, the lack of a numerical target for asset purchases (as under the old MBS programme), is clearly a concession to the uncertainty that prevails about this effect. Bernanke stressed that a general and a sustained improvement of the labor market is needed, and that the Fed did not have a specific number that captures when this would happen. The Fed states it clearly:

“If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability.”

Such a state-contingency is new in the recent series of quantitative easing, and it becomes interesting to see whether this will imply an ever-increasing balance sheet of the Fed, or a perhaps more potent result due to the expectation that this time it will work? At least, it is a rather bold policy measure.

As for the second category, communication, the Fed kept the date for when policy rates would be raised imprecise (as it has done previously), but moreover it added a commitment to keep rates low even after recovery starts:

“To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens. In particular, the Committee also decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015”

This comes close to the theoretical concept of optimal monetary policy in forward-looking New-Keynesian models, where history-dependence is optimal since it helps affect expectations about the future, and thereby current conditions directly. The reason is that history dependence implies that actions today will feed into the future, and thus the expectations about this future—given that the policy is credible. In particular, such history dependence of policy implies that an expansive stance should continue beyond the time where a given target is achieved.

Hence, the Fed’s decision comes close in accommodating the general ideas in the recently heavily mentioned paper by Michael Woodford on “Methods of Policy Accommodation at the Interest-Rate Lower Bound“ that was recently presented at the annual Jackson Hole Economic Policy Symposium (it is fantastic that a 95-page academic paper has gotten so much attention outside academia). Woodford has been the main academic economist emphasizing the advantages of history dependence in policy, and in this particular paper he makes the case for a nominal GDP-path target as a means to achieving this history dependence. (Ok, here I must state that originally nominal income growth targeting as a way of attaining history dependence was brought up by myself in a 1999 CEPR Discussion Paper that was published in 2002 as Targeting Nominal Income Growth or Inflation? American Economic Review 92, 928-956. Woodford noted this in his 2000 American Economic Review article on “Pitfalls of Forward-Looking Monetary Policy” which is a nice and brief introduction to the benefits of history dependence for those who are reluctant to dig into 95 pages.)

This issue was also brought up at the press conference, where the notion of credibility of the Fed was discussed. Whether the Fed has the necessary credibility is ultimately an empirical issue, and Bernanke found that empirics indicated good credibility—the aforementioned Jackson Hole paper by Woodford shows that announcements by the Fed affects bond yields almost immediately, indicating that communication matters. Nevertheless, it will be interesting to see whether the Fed (perhaps under another chairman) will keep rates low in an economy where inflation is picking up. This is a type of commitment that is hard to live up to, and one that cannot be assured from empirics on intra-day asset price movements following policy news.

Nevertheless, this meeting of the Board of Governors introduced an emphasis on state-contingency and commitment which is refreshing and goes nicely with academic literature (Bernanke is an ex-colleague of Woodford and has co-authored papers with him). Additionally, it was refreshing to see that these new policies are honest attempts to do something. Attempts that given their novelty by nature have no solid empirical support. Bernanke therefore also said that these measures offered no solution as such, but that the Fed thought that they will “nudge the economy in the right direction”. It will be interesting to follow.